America’s cliffhanger

The US fiscal cliff agreement, which passed through Congress on the first day of the year, showed most US politicians in a bad light.  Only at the very last minute before significant tax increases and spending cuts would have taken effect, did all participants agree to (i) a deferral of these measures for two months, (ii) a 4.6% tax increase on all incomes over $450,000, and (iii) a 2% payroll tax increase on all incomes up to $107,000.  Obama got the tax increase for the top 1% of earners that he had campaigned for, which will raise about $60bn a year, and the Republicans demanded no further extension of the payroll tax cut, which will raise about $125bn a year.  Together these measures will reduce US consumer incomes by a little over 1% of GDP in 2013.

This was just about the minimum possible level of agreement, and the fact that it took until 1st January to get to that point does not bode well for the chances of securing a more substantial and longer term agreement on government finances ahead of the next fiscal cliff deadline which is now 1st March.  However, several important conclusions can be drawn from recent events:

  1. All US politicians do now understand that the fiscal cliff deadline would have sent the US economy into recession if no agreement had been forthcoming, and that a failure to extend the US debt ceiling would lead to a technical default on US Treasuries with very negative consequences for markets.  Neither side wish to be seen as responsible for either of these events therefore future agreements will likely be made in time.
  2. Markets believe that agreements will always be made in time and so much less inclined to panic ahead of the fiscal deadlines.  Without markets exhibiting any such fear, the politicians have less reason to give ground in the negotiations until the very last minute.
  3. Obama has continued the style of his first term of not being prepared to engage directly with the Republican leaders in negotiations, preferring instead to call them to the White House in order to lecture them, and then leaving negotiations to others in his cabinet.  This is not helping to build goodwill and gather support, making substantive future agreements more difficult to achieve.
  4. Neither Republicans nor Democrats are actually very concerned about the levels of public debt ($16tr, more than 100% of GDP) and the budget deficit ($1tr a year) per se.  The Republicans are essentially opposed to any tax increases, which would tend to harm their supporters, and the Democrats are essentially opposed to any spending cuts, which would tend to harm their supporters.  There is some scope for tit-for-tat concessions here, but getting beyond the minimum acceptable levels to avoid market crises will be very difficult.
  5. This lack of strong commitment to deficit reduction makes it likely that there will be no meaningful austerity in the US until there are difficulties in selling the Treasury Bonds necessary to finance the deficits.  Given the weakness of the European economy following its efforts at austerity, this should support the US economy in the short term.
  6. The policy of the Federal Reserve is currently one of Quantitative Easing of $1 trillion per annum until further notice.  The Fed is providing the markets with enough new money to finance the budget deficit.  Ultimately, such a policy will lead to inflation and a collapse of confidence in the dollar.

The investment implications of the above are that US financial markets continue to be supported, in the short term, by a lack of austerity and continued printing of money, but that in the longer term, these same policies will lead to inflation and a credit crisis. With this outlook, investors should broadly remain invested in company shares, wary of bonds with fixed coupons and insured with gold.

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